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“War” Rally I
That was stage one of Iraq-related re-pricing.


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David Malpass

In case you missed it, the first stage of the Iraq-related re-pricing of the financial markets just hit. Oil and bond prices fell while equities and the dollar rose. Still, the current level of uncertainty is still seriously distorting market-based prices as well as perceptions of the economic outlook — and this won’t be resolved for several weeks.

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Rather than a “war rally,” the recent re-pricing is a logical response to the narrower timeframe for Iraq’s disarmament — March. The next stages of the Iraq-related re-pricing will depend on the many remaining Iraq uncertainties. These include:

— Turkey’s role in the conflict.

— Terrorism as the war starts.

— The length of the war.

— U.S. release of SPRO, its strategic petroleum reserve (not a certainty).

— Iraqi use of chemical and biological weapons.

— Any lasting damage to Iraqi oil and oil production.

The financial markets will only want to price in these risks as they become known. Also, not on this list is the future of the United Nations, and the expense or difficulty of the Iraq rebuilding effort.

In coming weeks, there should be several upgrades in the consensus economic outlook, somewhat paralleling the re-pricing process. With the dollar now at a relatively neutral value (locking in a reflation), some of the key Iraq-related economic variables are:

The price of oil several days into the war. This makes the SPRO release important, as well as Saddam’s ability to destroy or contaminate Iraqi and Kuwaiti oil. The U.S. faces a trade-off between using SPRO to get a much lower price of oil now versus its desire to work with Saudi Arabia and Arab oil producers (who have increased their oil production sharply in preparation for the war.)

The war’s direct impact on business confidence and investment. Depending on terrorist incidents and the length of the war, the economy may well enjoy a quick decline in risk aversion and a quick rebound in investment activity. In particular, pent-up investment, a 40-year low in the Fed funds rate, and a near-record low in the level of inventories relative to sales are all economic positives.

President Bush’s popularity. Tracking this is one way to measure whether the war is perceived to be a success.

The probability of the U.S. eliminating the double taxation of dividends. This is a critical factor in the outlook. The probability will change fast based on Bush’s popularity and the length of the war.

— Mr. Malpass is the Chief Global Economist for Bear Stearns.



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